The Economics of Networks: Sources of Network Externalities The Economics of Networks

3.1 Sources of Network Externalities

The key reason for the appearance of network externalities is the complementarity between
the components of a network. Depending on the network, the externality may be direct or
indirect. When customers are identified with components, the externality is direct. Consider
for example a typical two-way network, such as the local telephone network of Figure 2. In this
n-component network, there are n(n - 1) potential goods. An additional (n + 1th) customer
provides direct externalities to all other customers in the network by adding 2n potential new
goods through the provision of a complementary link (say ES) to the existing links.11

In typical one-way networks, the externality is only indirect. When there are m varieties
of component A and n varieties of component B as in Figure 4 (and all A-type goods are
compatible with all B-type), there are mn potential composite goods. An extra customer yields
indirect externalities to other customers, by increasing the demand for components of types A
and B and thereby (because of the presence of economies of scale) potentially increasing the
number of varieties of each component that are available in the market.

Financial exchange networks also exhibit indirect network externalities. There are two ways
in which these externalities arise. First, externalities arise in the act of exchanging assets or
goods. Second, externalities may arise in the array of vertically related services that compose
a financial transaction. These include the services of a broker, of bringing the offer to the floor,
matching the offer, etc. The second type of externalities are similar to other vertically-related
markets. The first way in which externalities arise in financial markets is more important.

The act of exchanging goods or assets brings together a trader who is willing to sell with
a trader who is willing to buy. The exchange brings together the two complementary goods,
"willingness to sell at price p" (the "offer") and "willingness to buy at price p" (the
"counteroffer") and creates a composite good, the "exchange transaction". The two original
goods were complementary and each had no value without the other one. Clearly, the
availability of the counteroffer is critical for the exchange to occur. Put in terms commonly
used in Finance, minimal liquidity is necessary for the transaction to occur.

Financial markets also exhibit positive size externalities in the sense that the increasing size
(or thickness) of an exchange market increases the expected utility of all participants. Higher
participation of traders on both sides of the market (drawn from the same distribution) decreases
the variance of the expected market price and increases the expected utility of risk-averse
traders. Ceteris paribus, higher liquidity increases traders' utility. Thus, financial
exchange markets also exhibit network externalities.12,
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